* Toyota, other top firms to offer 3 pct pay raises
* Overall increases 1 pct, less than sales tax hike
* Solid wage gains needed for economy to escape deflation
By Tetsushi Kajimoto and Yoko Kubota
TOKYO, March 12 Big Japanese companies such as Toyota Motor Corp will offer the most generous pay raises in years on Wednesday, but workers will still struggle to offset a sales tax increase, highlighting the difficulties the government is facing in overcoming entrenched deflation.
Toyota, Hitachi Ltd and Panasonic Corp will be among the firms announcing their responses to union pay demands after a year of soaring profits thanks to the weak yen and massive stimulus policies of Prime Minister Shinzo Abe.
But this first batch of companies in Japan's annual "spring labour offensive" represent the bluest of the blue chips; the vast majority of Japanese employees work for smaller companies that haven't benefited as much from "Abenomics."
"It's impossible for wage hikes to totally offset the impact of the sales tax hike," said Hisashi Yamada, chief economist at the Japan Research Institute. "It's hard to think wage hikes would spread among small firms as much as big firms."
Government spending and the Bank of Japan's enormous asset purchases have made a start in dragging the world's third-biggest economy out of 15 years of deflation and uncertain growth, but a durable recovery needs a cycle of rising profits, wages and prices.
Abe's government has been publicly pressuring companies to do their part and raise wages. Economy Minister Akira Amari on Tuesday appear to threaten government action against firms that don't comply.
"Companies that don't make any response, despite having higher profits, despite the government front-loading corporate tax cuts and transferring capital to them, are being uncooperative in contributing to a positive economic cycle," Amari said.
"The Ministry of Economy, Trade and Industry will take some kind of response."
Toyota will offer total compensation - base pay, seniority increases and bonuses - worth 7.6 percent more than last year, said a person with direct knowledge of the negotiations. This represents a comfortable lift for employees at the world's biggest carmarker. Excluding the bonus, it would mark the company's biggest pay raise in 21 years.
For major firms generally, though, total increases are likely to be around 3 percent, analysts say, just enough to cover the sales tax hike going into effect in April but not to offset the modest inflation the BOJ is trying to generate.
For the thousands of companies below the top tier - which employ the vast majority of Japanese workers - compensation is likely to be less generous.
For example, when big car makers such as Toyota raise base pay for their workers, they can squeeze suppliers to cut costs, putting downward pressure on their wages and diluting the economic lift of the wage gains at the top.
Including smaller firms - which have seen import costs rise due to the weak yen and which employ many part-timers and other irregular workers - Japanese workers overall may see their pay packets grow just 1 percent or so, analysts said.
"Purchasing power may at best break even for those at major firms," said economist Naoki Iizuka at Citigroup Global Markets Japan.
"A virtuous economic cycle needed for Abenomics goal of sustaining growth is not working at Japan Inc, and it is hard to imagine this year's wage talks will lead to such move."
Because bonuses rise and fall with the economy, a sustainable recovery will require solid gains in base pay so that people feel secure enough to increase spending, economists say.
Toyota will offer to raise base pay by 2,700 yen ($26.15) a month, or 0.8 percent, the first rise in this key compensation component in six years, the source said. But that is well below the 4,000 yen sought by workers.
Many Japanese firms remain wary of raising base pay due to doubts about over the recovery's sustainability and concern about higher fixed personnel costs, which are hard to shed during downturns.
Rengo, Japan's top labour federation, is calling this year for higher base pay for the first time in five years, citing the economic recovery. Japan's most influential business lobby, Keidanren, has also given a nod to raising base pay for the first time in six years.
Hitachi, Toshiba, Mitsubishi Electric Corp, NEC Corp, Panasonic and Fujitsu will all offer 1,000-2,000 yen raises in monthly base pay, versus union demands of 4,000 yen from the electronics companies. ($1 = 103.2350 Japanese Yen) (Additional reporting by Yuko Yoshikawa; Editing by William Mallard & Kim Coghill)